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The London FIX – Rig or Opportunity?

The colossal size of the FX market transcends any other, with an estimated daily turnover of $5.35 trillion. You have heard that at least THAT many times in your FX journey.

Now what you most probably haven’t heard, along with few other things regarding those trillions, not everything is as it is being served on the TV commercials, but we will address that in more depth in some of the future articles.

Here, we are interested only in the size of the market, exceeding 10 times its nearest competitor- the futures market. While the very size of the forex market should preclude the possibility of anyone rigging or artificially fixing currency rates, there are few piquants that you may not have heard about.

Get Acquainted with it’s Highness : The London FIX

The closing currency “fix” refers to benchmark foreign exchange rates that are set in London at 4 p.m. daily. Known as the WM/Reuters benchmark rates, they are determined on the basis of actual buy and sell transactions conducted by forex traders in the interbank market during a 60-second window (30 seconds either side of 4 p.m.).The benchmark rates for 21 major currencies are based on the median level of all trades that go through in this one-minute period. 

The importance of the WM/Reuters benchmark rates lies in the fact that they are used to value trillions of dollars in investments held by pension funds and money managers globally, including more than $3.6 trillion of index funds. Collusion between forex traders to set these rates at artificial levels means that the profits they earn through their actions ultimately comes directly out of investors’ pockets.

IM collusion and “banging the close”

Current allegations against the traders involved in the scandal are focused on two main areas:

  • Collusion by sharing proprietary information on pending client orders ahead of the 4 p.m. fix. This information sharing was allegedly done through instant-message groups – with catchy names such as “The Cartel,” “The Mafia,” and “The Bandits’ Club” – that were accessible only to a few senior traders at banks who are the most active in the forex market.
  • “Banging the close,” which refers to aggressive buying or selling of currencies in the 60-second “fix” window, using client orders stockpiled by traders in the period leading up to 4 p.m.

These practices are analogous to front running and high closing in stock markets, which attract stiff penalties if a market participant is caught in the act. This is not the case in the largely unregulated forex market, especially the $2-trillion per day spot forex market. Buying and selling of currencies for immediate delivery is not considered an investment product, and therefore is not subject to the rules and regulations that govern most financial products.

An example

Let’s say a trader at the London branch of a large bank receives an order at 3:45 pm from a U.S. multinational to sell 1 billion euros in exchange for dollars at the 4 pm fix. The exchange rate at 3:45 p.m. is EUR 1 = USD 1.2000.

As an order of that size could well move the market and put downward pressure on the euro, the trader can “front run” this trade and use the information to his own advantage. They therefore establishes a sizeable trading position of 250 million euros, which they sell at an exchange rate of EUR 1 = USD 1.1995.

Since the trader now has a short euro, long dollar position, it is in their interest to ensure that the euro moves lower, so that they can close out their short position at a cheaper price and pocket the difference. They therefore spread the word among other traders that they have a large client order to sell euros, the implication being that they will be attempting to force the euro lower.

At 30 seconds to 4 p.m., the trader and their counterparts at other banks – who presumably have also stockpiled their “sell euro” client orders – unleash a wave of selling in the euro, which results in the benchmark rate being set at EUR 1 = 1.1975. The trader closes out their trading position by buying back euros at 1.1975, netting a cool $500,000 in the process.

The U.S. multinational that had put in the initial order loses out by getting a lower price for its euros than it would have if there had been no collusion. Let’s say for the sake of argument that the “fix” – if set fairly and not artificially – would have been at a level of EUR 1 = USD1.1990. As each move of one “pip” translates to $100,000 for an order of this size, that 15-pip adverse move in the euro (i.e. 1.1975, rather than 1.1990), ended up costing the U.S. company $1.5 million.

Worth the risks

Odd though it may seem, the “front running” demonstrated in this example is not illegal in forex markets. The rationale for this permissiveness is based on the size of the forex markets, to wit, that it is so large that it is nearly impossible for a trader or group of traders to move currency rates in a desired direction. But what the authorities frown upon is collusion and obvious price manipulation.

If the trader does not resort to collusion, they do run some risks when initiating their 250-million short euro position, specifically the likelihood that the euro may spike in the 15 minutes left before the 4 p.m. fixing, or be fixed at a significantly higher level. The former could occur if there is a material development that pushes the euro higher (for example, a report showing dramatic improvement in the Greek economy, or better-than-expected growth in Europe); the latter would occur if traders have customer orders to buy euros that are collectively much larger than the trader’s 1-billion client order to sell euros.

These risks are mitigated to a great degree by traders’ sharing information ahead of the fix, and conspiring to act in a predetermined manner to drive exchange rates in one direction or to a specific level, rather than letting normal forces of supply and demand determine these rates.

So, the next time you are head -blown why the market moved like crazy around 4 pm London time and there were no news on the horizon, you’ll know, someone had their errands done.

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Fibo Rules

Fibonacci is a huge subject and there are many different Fibonacci studies with weird-sounding names but we’re going to stick to two: retracement and extension.

Few days ago my brother overheard me talking about the market and when I mentioned Fibonacci levels, in awe and surprise he almost yelled at me – What does Fibonacci has to do with your Forex, that is architecture!!!

So, for the sake of the peace in the world, let us first start by introducing you to the Fibo man himself…Leonardo Fibonacci, the king of the Castle!

No, no, he was not a king literally, and I doubt he had a castle, though his father was quite rich; and he is not some famous Italian chef, though he may sound like Pizza to you. You got partially right, he was Italian, and actually born in Pisa, but, he was a famous Italian mathematician, so, known as a super-duper uber ultra geek.

He had an “Aha!” moment when he discovered a simple series of numbers that created ratios describing the natural proportions of things in the universe. I had my “Ahaaaaa!” moment when I realized that his “Aha!” actually works.

The ratios arise from the following number series: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144…

This series of numbers is derived by starting with 0 followed by 1 and then adding 0 + 1 to get 1, the third number.

Then, adding the second and third numbers (1 + 1) to get 2, the fourth number, and so on.

After the first few numbers in the sequence, if you measure the ratio of any number to the succeeding higher number, you get .618.

For example, 34 divided by 55 equals .618.

If you measure the ratio between alternate numbers you get .382.

For example, 34 divided by 89 = 0.382 .

Well, now, that is way too serious. You can kill an elephant with all those numbers, though I don’t really see a point in killing an elephant. No one should kill an elephant for any reason.

Fibonacci Sequence

Back to the Fibo guy, enough elephants.

Fibonacci sequence is formed by taking 2 numbers, any 2 numbers, and adding them together to form a third number.

Then the second and third numbers are added again to form the fourth number.

And you can continue this until it’s not fun anymore… And the fun never ends, so don’t…  You should be trading, not adding numbers.

The ratio of the last number over the second-to-the-last number is approximately equal to 1.618.

This ratio can be found in many natural objects, so this ratio is called the golden ratio.

It appears many times in geometry, art, architecture, nature.

I have trillion more images to show that Fibonacci is everywhere, though some of them even I  personally don’t like seeing, like Sonic the Hedgehog, which I still don’t understand how came to obsess my nephew.

And where is Forex in all this?!

Didn’t I say Fibonacci is everywhere?

Fibonacci retracement levels work on the theory that after a big price moves in one direction, the price will retrace or return partway back to a previous price level before resuming in the original direction.

Traders use the Fibonacci retracement levels as potential support and resistance areas.

Haters my say since so many traders watch these same levels and place buy and sell orders on them to enter trades or place stops, the support and resistance levels tend to become a self-fulfilling prophecy.

Traders use the Fibonacci extension levels as profit-taking levels.

Again, word is that since so many traders are watching these levels to place buy and sell orders to take profits, this tool tends to work more often than not due to self-fulfilling expectations… But, as long as it works, who cares why ?

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